I promised a reply to Nick Rowe’s post in which he proposed that the neochartalist (NC) view of currency suffers from a stock-flow inconsistency.
I’m moving house, going to farewell events, enjoying a visit from my parents, and marking exams at the moment. So this isn’t going to be a very detailed reply. Anyway, I’ve been told to go in a less technical and more humane direction with my blogs, which suits me. But I did promise a reply. And I have a gap in my marking schedule. So here we go.
Rowe takes issue with the NC claim that the state, by imposing a tax payable only in a given currency, gives value to that currency. “Value” is a nightmare word from a philosophical point of view. Let me restate the claim thus. The answer to the question: “Why is there demand for currency?” is: “Because it is needed to pay taxes.”
Rowe comments as follows:
There’s a problem with that answer. Taxes are a flow; they have the units $/time. Taxes create a flow demand for intrinsically worthless bits of paper. But there is a stock of intrinsically worthless bits of paper; and that stock has the units $. And if that stock of paper is strictly positive and increasing over time, as it usually does, that means the flow supply of new paper created must exceed the flow demand for paper to pay taxes. So if flow supply exceeds flow demand, why doesn’t the market price of those intrinsically worthless bits of paper fall to zero?
I agree with that. If the government spends $2 for every $1 it taxes back, then a stock of dollars is building up somewhere. If people didn’t want to be building up that stock, then they would be spending the dollars, and the dollars would find their way back to the government as tax payments. Since that isn’t happening, clearly people want to build up their stock of dollars. There is a stock demand as well as a flow demand.
But I’m not sure I understand Rowe’s complaint about this. I think his point is that taxes can explain the flow demand but not the stock demand, so that the NC theory can’t be the whole truth. The fact that people need X dollars/year to pay tax explains why people are willing to give up goods and services for dollars. If people on the whole end up accumulating dollars in excess of X/year, there must be some other reason for wanting dollars. There is, but only in this sense: people are always unsure about precisely how many dollars they need each year, and they overshoot to be on the safe side.
In a world of perfect certainty, there would be no need to accumulate dollars: people would spend all their dollars (or whatever currency) buying what they need today on the spot market and everything they need tomorrow on the forward market. Cue the requisite Keynes quotations about money as the barometer of uncertainty.
Rowe then asks what it means for velocity if the state runs continued deficits and the price of currency is not falling.
Here we can think of velocity as the flow of currency out of the economy (tax payments) divided by the total stock of currency. As Rowe points out, the dimension of the velocity variable is 1/time. The variable for the flow of currency out of the economy has the dimension $/time, and that for the stock of currency has the dimension $. So construing velocity as the first divided by the second gets us to the right dimension.
Rowe rightly points out that if the state runs continued deficits, and the new dollars are added to the stock of currency rather than being spent, then velocity must be decreasing. But what, he asks, explains this continued decrease in velocity?
I think this is the same complaint in a second incarnation. A slowdown in velocity is, effectively, the building up of a stock. So again Rowe is suggesting that NC theory has no explanation for the building up of the stock. This time, he proposes an alternative theory:
The simple textbook’s ISLM model has a clear and simple answer …. It says that velocity is a positive function of the opportunity cost of holding money, so if money always pays 0% interest, a rise in the rate of interest on other assets will cause velocity to increase. You might not agree with that answer, but it is an answer.
Is it an answer? It seems to me to have no operational content. The rate of interest on an asset is a function of forward price / spot price: how much people will pay for the asset in the future relative to how much they pay for it today. So to say that velocity will increase if the rate of interest on other assets rises is just to say that if people will spend more on assets tomorrow then they will spend more on assets today. Increase in velocity today is explained by increase in velocity tomorrow. Tomorrow’s increase now stands in need of explanation, and if it is explained in the same way as today’s increase then we are embarked upon a regress in danger of collision with the heat death of the universe.
Cue quotations from Joan Robinson about how economic propositions dissolve into meaningless noises or circular arguments. I’ll stick with the NC theory until a contentful alternative comes along.
The primary cause of poverty, as a wise president once said, is lack of money. People need currency to buy what they need. Those who have what they need will only give it up for currency. Why? Because they want currency to supply their needs, and those who have what they need will only give it up for currency, for just the same reason. There is a chain of dependence, but it is well-founded. At the end you get to those who want currency because they need it to pay taxes or are uncertain about their future expenses and build up a buffer to be on the safe side.
Poverty exists, in other words, because the flow-supply from the currency issuer is inadequate to the flow-demand created by taxation plus the stock-demand created by uncertainty. Increase the flow-supply, or reduce the flow-demand, and the problem goes away.
Another option is to try to reduce the stock-demand by reducing uncertainty. Most central banking operations boil down in the end to such an attempt. But it is a most impalpable Snark-hunt, and while the central banks are busy trying to charm Uncertainty with smiles and soap, or threatening its life with a railway-share, the government could just be increasing spending or cutting taxes.